Afghanistan has made important achievements in recent years. The 2011 Article IV Consultation highlights that authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions. Directors agreed that the Extended Credit Facility (ECF)-supported program, accompanied by a technical assistance agenda, provides an appropriate framework for addressing the considerable challenges lying ahead and a basis for continued engagement with the donor community.

Abstract

Afghanistan has made important achievements in recent years. The 2011 Article IV Consultation highlights that authorities have taken steps to lay the foundation for economic stability and growth, despite a very difficult security situation and the challenges associated with building political and economic institutions. Directors agreed that the Extended Credit Facility (ECF)-supported program, accompanied by a technical assistance agenda, provides an appropriate framework for addressing the considerable challenges lying ahead and a basis for continued engagement with the donor community.

Afghanistan continues to be at a high risk of debt distress. 1,2 Following debt relief under the enhanced Heavily Indebted Poor Countries (HIPC) initiative and Multilateral Debt Relief Initiative (MDRI), Afghanistan’s external and public debt burden indicators improve in the near term. However, and as noted in the HIPC Initiative Paper prepared in early 2010, debt burden indicators could deteriorate rapidly if the country’s substantial financing needs were met with new loans, even concessional ones, instead of the current grant financing.3 In a nutshell, Afghanistan should restrict any borrowing to highly concessional financing for specific projects with a clearly identified economic return. The baseline scenario is optimistic, not least in terms of the assumption on security, and the probability of the alternative scenarios (or stress tests) is high; in many ways, the outlook could be characterized as bi-modal. The alternative scenarios, therefore, do not only illustrate Afghanistan’s vulnerability, but depict possible outcomes that reflect the challenges of envisaged transition and transformation in the wake of the withdrawal of large-scale foreign presence.

A. Baseline Scenario

1. The baseline macroeconomic scenario depicts an optimistic outlook predicated on a stable security situation. The political and economic backdrop in Afghanistan has altered since January 2010. The financial sector crisis and periods of foreign military withdrawal (transition) and gradual donor disengagement (transformation) are important developments that have entered the projections. Accordingly, the baseline has been revised in light of these recent changes. It also assumes that security will remain stable during the transition phase and that civilian foreign assistance will be reduced only gradually over the longer-term transformation. While this is clearly a desired outcome, it is by no means guaranteed. In comparison to the previous debt sustainability analysis (DSA),4 external and fiscal sustainability remains vulnerable to external shocks (Tables 1-6), and Afghanistan remains at risk of high debt distress.

Macroeconomic Assumptions Comparison Table

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Note: For current DSA, MT stands for medium term and reflects average over 2011-2015, and LT refers to long term reflecting average over 2016-2030. For previous DSA(January 2010), MT and LT correspond to the periods 2010-2014 and 2015-2029 respectively.

2. Projections are based on the progress made in 2010/11, marked by successful disinflation and economic growth. Under the baseline scenario, continued economic reforms, including improvements in governance and the business environment, will allow for major investment in the mining sector, agriculture, transport, and reconstruction. Accordingly, the nonagricultural sector is expected to outperform agriculture. In particular, Afghanistan has considerable potential in the mining industry, with exploitation of mineral wealth expected to begin in 2014/15.5 Over the medium term (2011/12-2015/16), real GDP growth is expected to average 6 percent, compared with 10 percent in the recent decade. Over the longer term (2025/26-2030/31), growth is projected to converge to 4 percent.6

Table 1.

Islamic Republic of Afghanistan: Medium and Long-Term Macroeconomic Framework, 2010/11-2029/30

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Source: Afghan authorities; and Fund staff estimates and projections.

Excluding the narcotics economy.

Comprising mainly current spending.

Defined as domestic revenues plus operating grants minus operating expenditures.

Defined as domestic revenues minus operating expenditures.

Includes official recorded exports, estimates of smuggling, reexports and sales to nonresidents.

Estimated direct expenditures by donors on public projects not included in the government budget.

After HIPC and MDRI debt relief, as well as debt relief beyond HIPC relief from Paris Club creditors. Debt includes obligations to the IMF.

3. While the overall macroeconomic situation is expected to improve, Afghanistan will likely remain dependent on donor support in the foreseeable future. Large financing gaps are projected for the remainder of this decade, and total donor support to finance both operating and development expenditures (on- and off-budget) is expected to remain substantial, at about US$3-4 billion per year by 2030/31. However, as the economy becomes increasingly self-sustained over time through economic growth, higher exports, and higher foreign investment, the share of total external support (the sum of grants and loans) to GDP is projected to decline from 35 percent in 2011/12 to 9 percent by the end of the 20-year projection period. While revenues are projected to increase to just under 19 percent of GDP by 2030/31, the share of grants in total external support is expected to decline gradually from 97 percent in 2011/12 to 76 percent at the end of projection period (equal to 6 percent of GDP). Such an increase in revenues over the long term will only be possible if the security situation is stable and the authorities implement key reforms in a timely manner.

4. Over the projection period, exports are expected to increase significantly, while somewhat lower growth in imports is associated with a decline of government-related imports, resulting from lower donor expenditure. Projections are based on the assumption that improvements in security, regional stability and economic reforms in combination with an enhanced investment climate, including in the mining sector, will contribute to higher total factor productivity. Basic infrastructure is expected to improve, allowing for some import substitution in light industries. In view of its unique geographical position, Afghanistan could develop into a regional hub in transit trade, with significant potential for exports of transportation services associated with trade between the Middle East and Central Asia. These are clearly very tenuous assumptions.

5. The current account deficit is projected to decline over the projection period. In 2010/11, officially recorded exports accounted for only 3 percent of GDP, while officially recorded imports reached 46 percent of GDP (of which donor-related imports amounted to 25 percent of GDP). Accordingly, the current account deficit (excluding official transfers)—which was high at 40 percent of GDP—is projected to decline to 26 percent by 2015/16 and further to about 6 percent at the end of the projection period, mirroring the projected decline in grants, in particular external budget grants (Figure 1.). The improvement in the current account will be supported by a continuous increase in exports and some import substitution. Under a more favorable scenario, if Afghanistan’s potential in the mining industry and in transit trade should be greater than assumed in the baseline, the current account deficit could decline faster in the outer years.

Figure 1.
Figure 1.

Afghanistan: Current Account Balance Excluding Grants

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 330; 10.5089/9781463925864.002.A003

Figure 2.
Figure 2.

Afghanistan: Current Account Balance Including Grants

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 330; 10.5089/9781463925864.002.A003

B. External Debt Sustainability Analysis

6. Following debt relief under the enhanced HIPC initiative and MDRI, Afghanistan’s external and public debt burden indicators have improved significantly. Afghanistan’s external public and publicly guaranteed debt amounted to US$1.3 billion, or 8 percent of GDP, in 2010/11. The bulk of this debt was owed to Paris Club and multilateral creditors. In present value terms, it reached about 4 percent of GDP at end-2010/11, or 72 percent of exports. Public external debt service was equivalent to 0.8 percent of exports of goods and services.

7. The present value of public external debt would gradually increase to about 12 percent of GDP by the end of the projection period under the baseline scenario. However, the present value of the debt-to-exports ratio is expected to breach the 100 percent threshold in the outer years of the projection period (Figure 3), implying the potential for debt distress. The indicative thresholds for the low-income country (LIC) DSA could be breached toward the end of the projection period.

Figure 3.
Figure 3.

Afghanistan: Indicators of Public and Publicly Guaranteed External Debt under Alternative Scenarios, 2011-30

Citation: IMF Staff Country Reports 2011, 330; 10.5089/9781463925864.002.A003

Sources: Country authorities; and Fund staff estimates and projections.
Table 2.

Islamic Republic of Afghanistan: Public and Publicly-Guaranteed External Debt, 2009/10-2015/16

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Sources: Country authorities; and staff estimates and projections.

According to the BOP Manual, a debt reorganization operation is considered to be completed and can be fully reflected in the balance of payments only if all preconditions mentioned in agreements are fulfilled. For agreements with the Paris Club, this provision is interpreted flexibly by regarding the signature of the Agreed Minute with the Paris Club as sufficient to treat such an agreement as completed in the BOP. The latter treatment has been followed by the staffs in preparing this Debt Sustainability Analysis.

Excludes Russian claims prior to their regularization via a Paris Club rescheduling.

Alternative Scenarios

8. Risks to the outlook are heavily on the downside, linked to security prospects, the strength of future reforms, and a deteriorating fiscal outlook.7 Should security remain fragile or worsen, economic growth would consequently suffer. Figure 3 presents the results of a customized alternative “lower-growth” scenario, in line with the scenario depicted in, Appendix II of the staff report. The “lower-growth” scenario (A1) depicts the absence of gains in security, governance, and public sector reforms, as well as a slower reform path with respect to financial sector reform and the business environment. A fragile security situation, in combination with delays in key reforms, would potentially discourage investment and external support, and result in lower exports, as well as a slowdown in revenue effort. With the possibility of delays of mining production, revenues from this sector would also suffer. Under this scenario, real GDP growth falls from 2 percent on average (instead of 6 percent in the baseline) in the medium term (2011/12-2015/16) to 1½ percent (instead of 4 percent in the baseline) in the long term (2025/26-2030/31). The present value (PV) of the debt-to-GDP ratio would reach 138 percent by the end of projection period, while the PV of the debt-to-exports ratio would reach 1,239 percent. Under this scenario, the remaining thresholds would also be breached with a significant margin. The second alternative scenario (A2) implies a deterioration of the fiscal outlook with lower resources and use of funds. Under this scenario, Afghanistan would face a rapid deterioration of debt- burden indicators, with the PV of the debt-to-GDP ratio reaching 118 percent and the PV of the debt-to-exports ratio projected at 1,068 percent by the end of the projection period.

9. Afghanistan remains at high risk of external debt distress.8 Given the sustained and large breaches of the thresholds under the alternative scenarios, the staffs of the IMF and World Bank continue to classify Afghanistan as “high risk”, based on guidance for debt distress assessments. A mild deterioration in the profile of donor grants even in the baseline could increase the risk of debt distress, further strengthening the rationale for the classification.

C. Fiscal Debt Sustainability

10. Public debt indicators grow markedly under the baseline (Table 5 and Figure 4). To enhance the monitoring of the domestic debt burden in the long run, the LIC DSA explicitly includes net domestic financing (NDF) and service obligations on this debt.9 Security-related expenditure will continue to account for a large share of operating expenditures. The baseline scenario assumes that (i) a value-added tax (VAT) will be introduced in 2014/15; (ii) a national tax and customs administration will be established in order to minimize political interference; (iii) the taxpayers segmentation approach will be strengthened further by enhancing the small, medium and large taxpayers offices; (iv) corruption will be combated by adopting modern business models and IT systems; (v) management will be strengthened to ensure that the reform momentum is maintained and more weight given to strategic planning of tax and customs operations; and (vi) minimal operations and maintenance expenditure (O&M) beyond those already included by the government in the operating budget. While development spending is expected to increase and raise potential GDP, investment will depend on the strength of reforms and a stable environment. In view of strong expenditure pressures expected on the budget, debt service of 6 percent of fiscal revenues by the end of the forecast period (over 2 percent of which is for servicing domestic debt) is of concern. The expansion of domestic debt reinforces the risk of a high debt distress rating.

Figure 4.
Figure 4.

Afghanistan: Indicators of Public Debt Under Alternative Scenarios, 2011-30 1/

Citation: IMF Staff Country Reports 2011, 330; 10.5089/9781463925864.002.A003

Sources: Country authorities; and Fund staff estimates and projections.1/ Revenues are defined inclusive of grants.

11. The alternative scenarios and stress tests demonstrate the fragility of Afghanistan’s economy. Under the scenario with permanently lower GDP growth (A1), debt service reaches about 34 percent of revenues by the end of the forecast period, leaving very limited fiscal space for investments or social expenditure. Risks to the outlook are also linked to revenue potential and grant financing. Figure 4 also presents the results of a customized alternative “lower sources and higher uses” scenario (A2).

12. The alternative scenarios look at risks to revenue targets and expenditure control. The “lower sources and higher uses” scenario assumes a reduction in revenues and grants while spending pressures increase. Specifically, the scenario incorporates a one-year delay in the implementation of the VAT as well as a reduction in revenue efficiency due to lagging reforms. This translates into an erosion in total revenue effort of approximately 1 percent of GDP on average over the horizon. At the same time, donors are assumed to disengage at a faster rate, through both on-budget and off-budget grants, with grants leveling off at the same proportion of GDP by 2030/31. To this we add increased operating expenditures from nonsecurity operations and maintenance (O&M) costs due to the takeover of projects and existing capital stocks from donors.10 Current estimates put these costs in the order of US$900 million in 2011.11 The customized scenarios highlight the importance of a stable revenue outlook and a level of grants and concessional borrowing in line with baseline projections. The explosive trajectory for expenditures due to O&M costs highlights the need for continued donor involvement, without which the primary balance moves into excessive deficit, triggering significant debt distress.

D. Conclusions

13. Afghanistan remains at high risk of debt distress after the HIPC completion point and the delivery of debt relief under the MDRI. Despite the substantial amount of debt forgiven under the HIPC and MDRI,12 continuing risks to the macroeconomic outlook and large financing needs underscore the importance of substantial and long-term grant financing, in combination with a strong reform agenda and progress in security and governance. Should donors decide to reduce aid rapidly and security fail to stabilize, or structural reforms and governance improvements lag, Afghanistan’s debt burden would quickly become unsustainable.

14. The authorities recognize the risks and are committed to ensuring debt sustainability. The government is cognizant of its responsibilities, but remains very concerned about the speed of donor withdrawal. Rapid exit by the international community could jeopardize the long-term reform process, which is critical to ensuring a favorable business and investment environment, and would place significant additional pressure on an already constrained pool of resources.

Table 3.:

External Debt Sustainability Framework, Baseline Scenario, 2008-30 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r - g - p(1+g)]/(1+g+p+gp)times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock

Historical averages and standard deviations are generally derived over the past 10years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Table 4a.

Afghanistan: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2011-2030

(In percent)

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Table 4b.

Afghanistan: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2011-2030

(In percent)

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Sources: Country authorities; and staff estimates and projections.1/ Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.2/ Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100percent. Net current transfers modelled as minus 1.5 times standard deviation.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Table 5.

Afghanistan: Public Sector Debt Sustainability Framework, Baseline Scenario, 2008-30

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

[Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.]

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.